Copyright 2018 Mitul Kotecha

Weekend developments in the trade war included China’s denial that they had reneged on any prior agreements, contrary to what the US administration has said as a rationale for ratcheting up tariffs on China. In fact, China’s vice-minister Liu He said that such changes (to the draft) were “natural”. He also said the remaining differences were “matters of principle”, which implies that China will not make concessions on such some key structural issues. This does not bode well for a quick agreement.

Meanwhile Trump’s economic advisor Larry Kudlow suggested that Trump and China’s President Xi could meet at the G20 meeting at the end of June. This offers a glimmer of hope but in reality such a meeting would achieve little without any agreement on substantive issues, which appears a long way off. Markets now await details from the US administration on tariffs on a further $325bn of Chinese exports to the US effectively covering all Chinese exports to the US.

China has promised retaliation and we could see them outline further tariffs on US exports in the next couple of days as well as the possible introduction of non-tariff barriers, making life harder for US companies in China. The bottom line is that any deal now seems far off while the risk of further escalation on both sides has risen. Global markets are increasingly taking fright as a result, especially emerging market assets.

There are no further negotiations scheduled between the US and China though Kudlow has said that China has invited Treasury Secretary Mnuchin and trade representative Lighthizer to Beijing for further talks. Given that Trump now appears to have a unified administration as well as many Republicans and Democrats behind him while China is digging its heels in this, don’t expect a resolution anytime soon.

China’s currency CNY is facing growing pressure as the US-China trade war escalates. The CNY CFETS index has weakened by around 1% in just over a week (ie CNY has depreciated relative to its trading partners) and is now at its weakest since 20 Feb 19. While not weaponising the currency, there’s every chance that China will manage CNY depreciation to help compensate Chinese exporters for the pressure faced from higher tariffs (as appeared to take place last summer). Expect more pain ahead.

At 12.01 EST the US escalated tariffs on China, following up on US President Trump’s tweets last weekend. The tariffs escalation follows what the US administration says was backtracking by China on a number of structural issues in an earlier draft of a trade agreement. Markets had been nervously anticipating this escalation all week, but also hoping that it could be avoided in some way.

A day of talks in Washington between Chinese officials led by Chinese vice-minister Liu He and US officials including US Trade Representative Lighthizer and Treasury Secretary Mnuchin failed to lead to any agreements or even any sign of progress despite President’s Trump’s tweeting that he received a “beautiful” letter from Chinese President Xi.

Talks are set to resume later but chances of any breakthrough appear slim. China appears to have taken a harder line on subordinating to some of the US demands for structural changes and don’t appear to have been too phased by the increase in US tariffs on $200bn of Chinese goods from 10 to 25%. The US side on the other hand appear to be taking a tough stance emboldened by the strength of the economy.

China has vowed retaliation but at the time of writing has not outlined any plans for any reciprocal tariffs. Trump has also stated that the US is preparing to levy 25% on tariffs on a further $325bn of Chinese goods though this could take some weeks to roll out. China does not however, appear unduly worried about talks extending further and may be content to play a waiting game.

Market reaction in Asia has been muted today and Chinese stocks have actually registered strong gains, reportedly due active buying by state backed funds, while the Chinese currency, CNY has registered gains. The USD in contrast has been under broad pressure.

Overall however, markets will end the week bruised and in poor shape going into next week unless something major emerges from the last day of talks. The CNY meanwhile, could end up weakening more sharply in the weeks ahead, acting as a shock absorber to the impact of higher tariffs on Chinese exports.

For more on this topic I will be appearing on CNBC Asia at 8.00am (Singapore Time) on Monday morning.

A trade deal between US and China appeared close to being agreed over recent weeks and markets had become rather sanguine about the issue. Indeed headlines over recent weeks had been encouraging, with both sides sounding conciliatory, and progress noted even on structural issues (technology theft, IP transfers, state subsidies, monitoring etc). Against this background the tweets by President Trump yesterday that he may increase tariffs on $200bn of Chinese imports to 25% from 10% on Friday and add another $325bn to goods that are not currently covered “shortly”, were all the more disturbing. Maybe such comments should not be so surprising, however.

The tweets need to be put into perspective. There may be an element of posturing from. It fits Trump’s style of deal making. In this case it appears that Trump and the China hawks in his administration are frustrated with the time taken to achieve a deal. Trump may also be emboldened to take a tougher stance by the resilience of the US economy, strength of US equity markets and limited impact on the US economy from current tariffs, though this would surely change if tariffs were ramped up. Trump may feel that such as gamble is worth it to take the deal across the line.

China’s reaction has been muted so far and talks this week in Washington may still be on, albeit with some delay. Assuming that discussions do take place Trump may feel that he has the stronger hand especially as there is broad political and public support for a strong stance on China. He may feel that if he agrees to a deal too easily, he could lose support from his core supporters, hence he is now doubling down on his stance. Pressure on China to agree on a deal sooner rather than later has clearly intensified as a consequence, but I would still take earlier statements that both sides are moving closer to a deal at face value.

Admittedly the stakes are higher now, but I would not be surprised if at some point in the talks, assuming they take place, the US administration declares that progress is being made and that tariff escalation is once again delayed. After all, that’s what has happened previously. Markets would be relieved of course, and the consequences of failure would be higher given the new tariffs at stake, but at least it would buy more time for China to avoid facing a ramp up in tariffs.

Market attention returns to China this week, with markets there opening after Chinese New Year Holidays. US/China trade talks will dominate attention, with China’s Vice Premier Lie Hu meeting with US Treasury Secretary Mnuchin and Trade Representative Lighthizer in Beijing. Tariffs are scheduled to be raised from 10% to 25% on $200bn worth of Chinese exports to the US on March 2. If talks do not succeed it will act as another blow to the world economy.

The fact that US President Trump has said that he won’t meet China’s President Xi Jinping before March 1 suggests elevated risks of a no deal though both sides. Moreover, US officials will be wary of being seen to give in to China given the broad based domestic support for a strong stance against China, suggesting that they will maintain a tough approach. Even so, there is a huge incentive to arrive at a deal of sorts even if structural issues are left on the back burner.

At a time of slowing global growth and heightened trade tensions China’s January trade report will also be scrutinised this week. Market expectations look for a sizeable 10.3% y/y drop in imports and a 3.3% y/y fall in exports. The risks on imports in particular are skewed to the downside given the weakness in exports data from some of China’s trading partners in the region including South Korea, Taiwan, Singapore and Vietnam. A weak outcome will result in a further intensification of concerns about China’s economy.

Another focal point is the direction of China’s currency (CNY). As trade talks continue this week it is likely that China maintains a relatively stronger currency stance via stronger CNY fixings versus USD and stronger trade weighted (CFETS CNY nominal effective exchange rate). As it is the CFETS index is currently around its highest level in 7 months. Of course, if trade talks fail this could easily reverse as China retaliates to an increase in US tariffs.

A major focus for markets next weeks is the US/China trade talks in Washington. After the US reportedly turned down an offer of preparatory talks this week talks will begin on Monday, with China’s Vice Commerce Minister, Vice Finance Minister and central bank, PBoC governor.

It is unclear who on the US side they will meet, but the idea is to prepare the ground for the heavy weight talks between US Trade Representative Lighthizer, US Treasury Secretary Mnuchin and China’s top economic official Liu He, from Jan 30 to 31.

Both sides need a win on trade and markets are pinning their hopes on some form of a deal. The reality is that they are still very far apart on a number of issues. As highlighted by US commerce secretary Ross, a trade deal is “miles and miles” away.

The easier issues on the table are increased purchases of US goods by China, something that China has already said they will do, in order to help reduce the record Chinese trade surplus with the US. The tougher issues are more structural, including forced technology transfers, state subsidies, discrimination against foreign companies, regulations on intellectual property etc.

Not only is the US determined to gain China’s agreement on the above issues, but is also looking to find ways to ensure compliance monitoring. However, China does not believe that foreign companies are transferring technology to Chinese companies, while they have already offered measures to increase access to foreign investors. Overall, this means there is little room for negotiation.

In any case with just over a month left before the March 1 deadline that President Trump has set before he imposes increased tariffs of 25% on around half of Chinese exports to the US, there is little time to thrash out a deal on the key structural issues that would likely satisfy the US administration.

The likelihood is that negotiations will not be completed, especially on structural issues, leaving markets very little to be excited about. While both sides may leave the talks, claiming a degree of progress, this will not be sufficient to allay concerns. Risk assets will look vulnerable against this background.

As the end of the year approaches it would take a minor miracle of sorts to turn around a dismal performance for equity markets in December. The S&P 500 has fallen by just over 12% year to date, but this performance is somewhat better than that of equity markets elsewhere around the world. Meanwhile 10 year US Treasury yields have dropped by over 53 basis points from their high in early November.

A host of factors are weighing on markets including the US government shutdown, President Trump’s criticism of Fed policy, ongoing trade concerns, worries about a loss of US growth momentum, slowing Chinese growth, higher US rates, etc, etc. The fact that the Fed maintained its stance towards hiking rates and balance sheet contraction at the last FOMC meeting has also weighed on markets.

A statement from US Treasury Secretary Mnuchin attempting to reassure markets about liquidity conditions among US banks didn’t help matters, especially as liquidity concerns were among the least of market concerns. Drawing attention to liquidity may have only moved it higher up the list of focal points for markets.

The other major mover is oil prices, which have dropped even more sharply than other asset classes. Brent crude has dropped by over 40% since its high on 3 October 2018. This has helped to dampen inflationary expectations as well as helping large oil importers such as India. However, while part of the reason for its drop has been still robust supply, worries about global growth are also weighing on the outlook for oil.

But its not all bad news and markets should look at the silver lining on the dark clouds overhanging markets. The Fed has become somewhat more dovish in its rhetoric and its forecasts for further rate hikes. US growth data is not weak and there is still sufficient stimulus in the pipeline to keep the economy on a reasonably firm growth path in the next few months. Separately lower oil is a positive for global growth.

There are also constructive signs on the trade front, with both US and China appearing to show more willingness to arrive at a deal. In particular, China appears to be backing down on its technology advancement that as core to its “Made In China 2025” policy. This is something that it at the core of US administration hawks’ demands and any sign of appeasement on this front could bode well for an eventual deal.

After yesterday’s carnage, global equity markets have recovered some of their poise. Whether this is a pause before another wave of pressure or something more sustainable is debatable. It appears that US equities are finally succumbing to a plethora of bad news. Higher US yields have driven the equity risk premium lower. Also there’s probably a degree of profit taking ahead of the onset of the Q3 US earnings season.

At the same time valuations have become increasingly stretched. For example, the S&P 500 price/earnings ratio is around 6% higher than its 5 year average while almost all emerging market price/earnings ratios are well below their 5 year averages. While strong US growth prospects may justify some or even all of this differential, the gap with emerging markets has widened significantly.

While US President Trump blames an “out of control” US Federal Reserve, it would have been hard for the Fed to do anything else but raise policy rates at its last meeting. If the Fed didn’t hike at the end of September, bond yields would like have moved even higher than the 3.26% reached on the 10 year US Treasury yield earlier this week as markets would have believed the Fed is falling behind the curve. However, as US yields rise and the equity risk premium reacts, the opportunity cost of investing in equities rises too.

In the FX world the US dollar could succumb to more pressure if US equities fall further but as we saw yesterday, USD weakness may mainly be expressed versus other major currencies (EUR etc). Emerging market currencies continue to face too many headwinds including higher US rates and tightening USD liquidity, as well as trade tariffs. The fact that emerging market growth indicators are slowing, led by China, also does not bode well for EM assets. Unfortunately that means that emerging market assets will not benefit for the time being from any rout in US assets despite their valuation differences.

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